The recent US Appeals Court ruling in the case of NML Capital Ltd. vs. Republic of Argentina upheld the right of holdout creditors to be paid in full, based on the pari passu clause included in bond contracts. In principle, the ruling can have significant implications for the successful completion of future sovereign bond restructurings, as it can diminish creditor incentives to participate in debt restructurings and can also increase the threat of litigation.

However, we find that in practice implications could prove limited in many situations:

»    Not all sovereign bond contracts have the same formulation of the pari passu clause as Argentina’s bonds. In fact, one of the three common formulations of the pari passu clause, found in the majority of bonds issued over the past two decades and in almost all bonds issued earlier, poses a lower risk of holdout litigation.

»    The vast majority of foreign-law sovereign bond contracts contain Collective Action Clauses (CACs), which set a lower threshold for the completion of a successful debt exchange. Moreover, as in the case of Greece earlier this year, CACs can be retroactively inserted in local-law bonds by act of legislation. Thus, the pari passu clause risk is more applicable to New York law bonds issued before 2003, which contain pari passu clauses but no CACs.

»    It can be possible in future sovereign bond restructurings to legally subordinate holdout bonds, for example by using exit consents.

»    The case of Argentina is not the first instance in which a court enforced a pari passu clause in a sovereign debt instrument. The precedent was set back in 2000 by the court ruling in the case of Elliott vs. Peru, which granted the hedge fund Elliott Associates an injunction against Peru, prohibiting it from paying foreign creditors unless pro rata payments were made to all creditors who ranked pari passu. Despite the furor the injunction caused at the time, sovereign holdout litigation has not been a major impediment to debt restructuring over the last decade.

In this report, we summarize the different aspects of the potential implications of Argentina’s court ruling for future sovereign debt restructurings. This comment does not represent a

legal opinion or interpretation but summarizes our views on the potential credit implications in light of the structure of sovereign bond contracts and past experience with sovereign restructurings. In addition to the issues analyzed in this report, the court ruling can have direct impact on Argentina’s ability to remit payments to restructured bondholders, which is analyzed separately in Legal Ruling Raises Questions About Argentina's Debt Payments.

Background: US Appeals Court ruled in favor of holdout creditors on the basis of the pari passu clause in bond contracts

On October 26, US Appeals Court ruled to uphold an injunction against Argentina in favor of holdout creditors with US$1.33 billion in defaulted claims. The court held that Argentina is to comply with the pari passu or equal treatment clause in its bond contracts and that it cannot discriminate against the holdout bonds in favor of the bonds issued in the 2005 and 2010 sovereign debt restructurings. The Appeals Court also returned the case to the District Court requiring clarification on the amount to be paid to holdout bondholders and on how to apply the ruling to financial intermediaries.

On November 21, District Judge Griesa resolved the issues remanded to him by the Second Circuit

Court in favor of the plaintiffs. Judge Griesa ruled that the holdout creditors are to be paid in full, i.e.

100% of accelerated principal and accrued interest, and that the paying agent on the restructured

bonds (Bank of New York) is subject to the injunction – meaning that funds remitted to Bank of New

York for payment on the restructured bonds are potentially available for payment instead to the

holdout creditors.

Most recently, on November 28, the Appeals Court extended the stay of the injunction (which otherwise would have gone into effect on 15 December 2012) and provided a timetable for the appeals process, with oral arguments due on 27 February 2013.

The ruling potentially affects the coupon payments on restructured Argentinean debt (see Legal Ruling Raises Questions About Argentina's Debt Payments), but does not attach any Argentinean property. Instead, it represents an order for Argentina to comply with its contractual obligations not to alter the rank of its payment obligations and to pay holdout creditors in full whenever restructured bondholders are paid. Restructured bondholders represented 92% of the claims in the 2005 and 2010 debt restructurings, while holdout creditors represent the other 8% amounting to approximately US$12 billion.

Potential implications for future sovereign debt restructurings

The court ruling significantly strengthens the pari passu clause in sovereign bond contracts, favoring holdout creditors in existing cases where the untendered bonds were not de jure subordinated. By setting precedent under New York law in requiring sovereigns to pay holdout creditors in full, and

thus shifting power to holdout creditors, the ruling could create disincentive for creditors to participate

in future sovereign debt restructurings.

In principle the court ruling can have significant implications for the successful completion of future sovereign bond restructurings. In practice, however, the impact of the ruling could prove more limited in many situations.

Pari passu clauses are not all equal

Pari passu clauses are ubiquitous in sovereign bond contracts. As Exhibit 1 shows, pari passu clauses were commonly included in unsecured bond contracts since the 1960s and at present are included in almost all new issuances. However, not all sovereign bond contracts have the same formulation of the pari passu clause as Argentina’s bonds. In fact, one of the three common formulations of the pari passu clause, found in the majority of bonds issued over the past two decades and in almost all bonds issued earlier, poses a lower risk of holdout litigation.

Notes: Dataset of over 1300 contracts and disclosure documents for sovereign bonds issued between 1823 and 2010.

Source: Weidemaier, Scott and Gulati (2011).

There are three common versions of the wording of the pari passu clause. The first version, and the version commonly used before 1990, provides that “the bonds rank pari passu with all External Indebtedness”. This version of the clause is generally considered not readily susceptible to the ratable payment interpretation. The “medium risk” version might state that “the bonds will rank pari passu in priority of payment and in rank of security”. Finally, the “high risk” version adds “and shall be paid as such” to the “rank equally” clause. The last two versions are more susceptible to the ratable payment interpretation as they explicitly require equal treatment at the moment of payment. According to the empirical evidence in Weidemaier, Scott and Gulati (2011), sovereign bonds increasingly began to incorporate the two “more risky” versions only in the 1990s and 2000s; about two-thirds of sovereign bonds issued in the 1990s and almost half of the bonds issued in the 2000s contained the “low risk” version of the pari passu clause.1

Further, Argentina’s case is unique in that Argentina passed a law in 2005, the so-called “Padlock Law”, that forbade the government to settle with holdout creditors who had refused to participate in the restructuring. The law effectively granted preferential status to one group of creditors. Should the Appeals Court choose to interpret the ruling in a narrow sense related to the Padlock Law, rather than in a broader sense related to the pari passu clause, the implications of the ruling for other sovereigns could be limited.

CACs set a lower threshold for the completion of a restructuring

In practice, the court ruling is likely to have limited impact in cases where bond contracts include Collective Action Clauses (CACs). CACs allow a supermajority of creditors to amend the instrument’s payment terms and other essential provisions. CACs thus allow a supermajority of bondholders to agree to a debt restructuring that is legally binding on all holders of the bond, including those who

vote against the restructuring.

1       Weidemaier, M., Scott, R. and Gulati, M., Origin Myths, Contracts, and the Hunt for Pari Passu, mimeo available on ssrn.com, 2011.

As Exhibit 2 shows, in New York law bonds, CACs became popular after 2003 and are currently commonly included in almost all New York law issuances. The typical threshold for modification of payment terms is a supermajority of 75% of bondholders. Therefore, the pari passu clause risk is more relevant for older New York law bonds which include pari passu clauses but do not include CACs, and thus require 100% bondholder approval for modification of payment terms.

EXHIBIT 2

Notes: Dataset of 312 sovereign bonds issued between 1986 and 2007.

Source: Bradley, Cox and Gulati (2008). 2                                                                                                                                                                                                              

The CAC term is used less frequently in English law bonds, however English law bonds at least since the 1990s typically contain modification clauses, which enable bondholders to approve a restructuring in a vote that binds even dissenting bondholders. Modification clauses in English law bonds require between 18.75% and 75% voting thresholds, thus acting similarly to CACs in New York law bonds.

Further, bonds issued under domestic law can be restructured by retroactively inserting CACs in the bonds by an act of legislation, as was done in Greece earlier this year.

Therefore, the impact of the pari passu clause ruling would primarily apply to New York law sovereign bonds, issued before 2003, which contain pari passu clauses but no CACs and thus require 100% participation for modifying the payment terms on the bonds. (The vast majority of sovereign bonds

are issued under US or UK law; only a very small portion of the market is governed by German or

Japanese law.)

We note that CACs apply to individual bond series and thus have a limitation. Taking blocking positions in individual bond series is possible while still achieving a high overall participation rate in the restructuring process. Aggregate CACs could address this problem in the future, but they are not yet widely used.

In principle, it can be argued that even with CACs the court ruling (if upheld) could make future restructurings more difficult: if the expanded view of pari passu allows holdout creditors to collect

100%, it may make it more difficult to reach the necessary 75% threshold for the CACs to be

triggered. In this case, however, the “prisoner’s dilemma” argument would apply as nobody will receive

any payment if a restructuring does not get agreed upon.

2       Bradley, M., Cox, J. and Gulati, M., The Market Reaction to Legal Shocks and Their Antidotes: Lessons from the Sovereign Debt Market, Duke Law School

Scholarship Series, Paper 120, 2008.

Exit consents could be used to subordinate holdouts

It can be possible in future sovereign debt restructurings of foreign law bonds to legally subordinate holdout bonds. One potential mechanism is to waive the pari passu and negative pledge clauses on old debt using exit consents, which typically require lower levels of bondholder approvals.

Exit consents are a formal agreement that allows a majority group of creditors to change the non- financial terms of the bonds in a way that makes them largely worthless for the minority holdouts. While amendments to financial terms may require unanimity, other terms may normally be amended by a majority or supermajority of creditors. Indeed, exit consents have been used in past restructurings to give an incentive to all creditors to participate in the exchange, most commonly removing the cross- default and cross-acceleration clauses from the old bonds and lifting the listing requirement.

Argentina is unique in its treatment of holdouts

Finally, Argentina is unusual in its refusal to consider any payments to holdout creditors. In a number of other recent sovereign debt restructurings, governments have adopted an approach that puts aside payments to holdout bonds in an escrow account, typically with the central bank, in preparation that holdouts might decide to tender claims later on. As payments to the holdout bonds are made along with payments to restructured bonds and on the same terms, it is unclear what the legal interpretation of the pari passu clause in such cases might be.

No implications for reserve assets

We do not believe that the court ruling could create a precedent for a broader set of sovereign holders of reserve assets in the US. Sovereign reserve assets and central bank assets are exempted from attachment under the Foreign Sovereign Immunities Act (FSTA) and this immunity has been upheld in past legal proceedings.

Possible implications for official sector creditors

The court ruling could potentially have implications for official sector creditors, including the IMF. The IMF and official sector creditors enjoy preferential “senior” creditor status. This status is conveyed by practice, but it is not enshrined in law. The court ruling, which strengthens the pari passu clause in bond contracts and stipulates equal treatment of creditors, could potentially raise questions about the “senior” status of official sector lenders.

In practice, however, official sector debt (except IMF debt) is frequently restructured along with

private sector debt, and often on similar terms. Moreover, the court has explicitly stated that it was not

called to rule on whether ‘preferential payments’ to official lenders could breach the pari passu clause

and was careful to note that holdout creditors had not challenged the IMF’s status. At this point, it is

uncertain whether the future legal interpretation would be that this preserves official lenders’ status or

leaves it open to challenge.

Implications on the ability to enforce

Judge Griesa ruled that the paying agent on the restructured bonds is subject to the injunction. This could potentially raise concerns that holdout creditors will be able to seek legal remedy from third parties that assist a sovereign debtor.

However, it is unclear if this ruling can have some real implications for the ability to enforce a court ruling or to attach payments in future litigation as precedent already exists – as summarized in Box 1, the case of Elliott vs. Peru had set a precedent for attaching payments though financial channels back in

2000. Despite the furor the injunction caused at the time, sovereign holdout litigation has not been a major impediment to debt restructuring over the last decade.

The Case of Elliott vs. Peru3

The case of Argentina is not the first instance in which a court enforced a pari passu clause in a sovereign debt instrument. The precedent was set back in 2000 by the Brussels Court ruling in the case of Elliott vs. Peru (following a number of US court rulings), which granted the hedge fund Elliott Associates, the same hedge fund specializing in distressed debt, an injunction against Peru, prohibiting it from paying foreign creditors unless pro rata payments were made to all creditors who ranked pari passu.

Elliott Associates had purchased working capital debt of Banco de la Nacion, guaranteed by the Republic of Peru. Elliott refused to participate in Peru’s Brady Plan restructuring in 1996 and filed suit against the debtors. Elliott obtained judgment for the full principal amount of the debt in July

2000, but in order to collect any payment it had to be able to seize some of the sovereign’s funds

abroad. Elliott came up with the creative solution to attach the payments about to be made to Peru’s

other creditors under the Brady Plan restructuring. After failing to attach funds transferred to Chase

Manhattan Bank, which was acting as a fiscal agent for Peru, Elliott succeeded in attaching funds

transferred through Euroclear. At this point, Peru opted to settle with Elliott for $56.3 million

rather than defaulting on the Brady bonds, whose grace period was running out.

Final ruling is still to come

There is still considerable degree of uncertainty about the eventual outcome of the legal proceedings in the case of Argentina and about the time it will take to resolve the case. The Appeals Court ruling is still to come, and even after that, Argentina could still choose to petition the case to the Supreme Court.

3       Verdier, P.H., Credit Derivatives and the Sovereign Debt Restructuring Process, Harvard Law School Working Paper, 2004 and Moody’s Special Comment,  How To

Sue A Sovereign - The Case Of Peru, November 2000.

Moody’s Related Research

Special Comments:

»    Legal Ruling Raises Questions About Argentina’s Debt Payments, November 2012 (147437)

»    Sovereign Defaults Series: Sovereign Debt Restructurings Provide Liquidity Relief But Often Do

Not Reduce Debt Levels, November 2012 (146909)

»    Sovereign Defaults Series: Investor Losses in Modern-Era Sovereign Bond Restructurings, August

2012 (144129)

»    Sovereign Default and Recovery Rates, 1983-2012H1, July 2012 (144320)

»    The Causes of Sovereign Defaults: Ability to Manage Crises Not Merely Determined by Debt

Levels, November 2010 (127952)

»    Market Use of Sovereign Ratings, September 2010 (127353)

»    Sovereign Defaults and Interference: Perspectives on Government Risks, August 2008 (110114)

»    How To Sue A Sovereign: The Case Of Peru, November 2000 (61737)

»    Sovereign Debt: What Happens If A Sovereign Defaults, July 2000 (57753)

Issuer Comment:

»    Province’s Default Is Credit Negative for All Foreign Currency Debt from Argentina, October

2012 (146373)

To access any of these reports, click on the entry above. Note that these references are current as of the date of publication of this report and that more recent reports may be available. All research may not be available to all clients.

Report Number: 147881

Author

Elena Duggar

Associate Analyst

Madhi Sekhon